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Intro - Classical Theory of International Trade ↓

In 1817, David Ricardo, an English political economist, contributed theory of comparative advantage in his book 'Principles of Political Economy and Taxation'. This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade.

According to the classical theory of international trade, every country will produce their commodities for the production of which it is most suited in terms of its natural endowments climate quality of soil, means of transport, capital, etc. It will produce these commodities in excess of its own requirement and will exchange the surplus with the imports of goods from other countries for the production of which it is not well suited or which it cannot produce at all. Thus all countries produce and export these commodities in which they have cost advantages and import those commodities in which they have cost disadvantages.

Types of Cost Difference in Production ↓

Economists speak about three types of cost difference in production, they are

Absolute cost difference,

Equal cost difference, and

Comparative cost difference.

1. Absolute Cost Differences :-

Adam Smith in his book 'Wealth of Nation' argued that international trade is advantageous for all the participating countries only if they enjoy absolute differences in the cost of production of the commodity which they specialise. As in the case of individuals where each specialises in the production of that commodity in which he has an absolutely superiority in terms of cost, so also each country specialises in production of goods based on absolute advantage.

The principle of absolute difference in cost can be explained with the help of table given below. Let us assume that we have 2 countries, I and II specialising in the production of X and Y.

In country I, one day's labour produces 20x or 10y. The internal exchange rate is 2 : 1. In country II, one day's labour produce 10x or 20y which gives us the domestic exchange rate of 1 : 2. Country I has the absolute advantage in the production of X (as 20 > 10) and country II in Y ( as 10 < 20). If these countries enter into trade with the international exchange of 1 : 1, both countries stand to benefit. Country I will have 1y for 1x as against 1/2y for 1x within the country. Similarly country II will have 1x for 1y as against 1/2x for 1y within the country.

Based on this example, according to Adam Smith, it can be pointed out that international trade to be beneficial, each country must enjoy absolute difference in cost of production.

2. Equal Difference in Cost :-

Adam Smith, in order to strengthen his argument in favour of absolute difference in cost pointed out that trade is not possible if countries operate under equal difference in cost instead of absolute difference.

The above table gives us the internal exchange rate 2x : 1y in both countries. Since the exchange ratio between X and Y in both countries is the same; none of them will benefit by entering into international trade.

Based on this example, according to Adam Smith, for international trade to be beneficial countries must enjoy absolute difference in cost. Trade would not take place when the difference in cost is equal.

3. Comparative Difference in Cost :-

David Ricardo agreed that absolute difference in cost gives a clear reason for trade to take place. He, however, went further to argue that even that the country has absolute advantage in the production of both commodities it is beneficial for that country to specialise in the production of that commodity in which it has a greater comparative advantage. The other country can be left to specialise in the production of that commodity in which it has less comparative advantage. According to Ricardo the essence for international trade is not the absolute difference in cost but comparative difference in cost.

Ricardo's Theory of Comparative Advantage ↓

David Ricardo stated a theory that other things being equal a country tends to specialise in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.

1. Ricardo's Assumptions :-

Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each good.

Labour is homogeneous i.e. identical in efficiency, in a particular country.

Labour is perfectly mobile within a country but perfectly immobile between countries.

There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.

Production is subject to constant returns to scale.

There is no technological change.

Trade between two countries takes place on barter system.

Full employment exists in both countries.

There is no transport cost.

2. Ricardo's Example :-

On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities.

As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.

Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.

• Cost ratios of producing Wine and Cloth ↓

Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5 — 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21).

Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.

• Comparative Cost Benefits Both Participants ↓

Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.

Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1.

At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.

Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.

In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage.

Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.